One World Recession, Ready or Not

The usual grounds for optimism these days is the fact that the Obama Administration is clearly going to propose a big fiscal package with two components: a large conventional stimulus (spending plus tax cuts); and a big housing refinance scheme, in which the Treasury will potentially become the largest-ever intermediary for mortgages.

These ideas are appealing under the circumstances, but this Fiscal First approach also has definite limitations, for both domestic and foreign reasons.

Most obviously, Congress will reasonably want to impose constraints on the amount of government debt that is issued, particularly absent a longer-term solution for Social Security and Medicare.

In addition, the Administration’s big deficit push relies critically on an “easy enough” monetary policy which, at the same time, precludes “too much money, too soon.” They need long interest rates to remain low, particularly for the housing scheme to make sense – rates have to come down for borrowers, at the same time as there is sufficient margin to cover credit losses, so it only works if the 10-year Treasury rate is roughly at current levels.

If the Fed eases “too much,” then actual or expected inflation will jump. This would reduce real debt burdens and could help reflate the US and global economy more broadly, but the higher interest rates would compromise the fiscal/housing strategy. (If the Fed holds down long rates in the face of sharply rising inflation expectations, then will we will have a crazy credit boom that makes all other bubbles seem relatively sensible.)

On the foreign side, all other governments have an incentive to free-ride on the US fiscal policy. The dollar will tend to appreciate, on top of any strengthening due to safe haven-related developments. Both Europe and leading emerging markets can, in this scenario, hope to recover based on their exports. Sure, they like to criticize the US for its role in placing everyone on fragile growth paths with increasingly hard-to-sustain debt paths, but almost everyone would like – in the short-term – to go right back there.

Again, if the US approach were more slanted towards expansionary monetary policy, this would tend to cause dollar depreciation and it would force the hand of other governments. Either they would ease their own interest rates and potentially increase their supply of money, or their export sectors and growth would suffer further.

Most countries around the world have limited capacity for fiscal expansion, but almost all could engage in a more expansionary monetary policy. This, of course, runs counter to 20 years of orthodoxy in central banking, but nothing is without risks. And that includes the first set of fiscal moves by the Obama Administration in their global economic chess game.

9 responses to “One World Recession, Ready or Not”

Inflation on the other side of this crisis is going to be really nasty. I don’t think there will be an ability to purge the excess cash from the system when it needs to happen. Its not like there are any stipulations on the money being given out to require immediate repayment if requested. I guess at this point in the crisis that seems like a weird stipulation, but not looking down the road is part of what got us here in the first place. I don’t think anyone can predict when that day will come, it could be late 2009 or years away. My guess is that some of it will get dropped in the market and everyone will be screaming about inflation which will cause another contraction in the monetary supply. Rinse and repeat, I guess.

Is it not possible to engineer mortgage rates independent of other interest rates (10 year Treasury rates)? Aren’t the mortgage rates dependent on the amount of Fannie and Freddie debt and securities that the Fed purchases?

If there is independence of Treasury and mortgage rates, then it seems the Fed should be able to accomplish the two tasks at the same time: holding mortgage rates at about 4.5% and moderating other interest rates up and down as required to expand the economy while protecting against rampant inflation.

I fear that the question I posed above, dealing with the interdependence of mortgagge rates and ten year treasury rates, may have been a stupid one. I suspect that mortgage rates are closely tied to the rates of 10 year treasury notes, but I am not certain.

I would like to make a suggestion to the authors of this blog. It might be helpful to say a bit about the interrelationships of the various interest rates. How does the Feds funds rate, just targeted close to zero, affect other rates? Are 10 year treasury rates closely tied to 30 year mortgage rates? What are the prime factors which affect interest rates?

This seems to be a very confusing topic and I would guess I am not the only one confused by it. The authors of this blog have done an excellent job of explaining the different facets of the financial crisis for the general public. The important interest rates and how they are interrelated might be another topic that could be discussed.